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The Subprime Mess: What's Happening Now and What's Next?

In the summer 2007 issue of Central Banker, I talked about why sub-prime lending is news and will continue to be. At the time, I could not foresee the impact that this specialized type of lending would have on financial markets in general. So, what happened and what's to come?

In August, financial markets stopped functioning normally. While there were many contributing factors, one reason for the market disruption was that investors were uncertain about the extent and ownership losses of sub-prime mortgage debt securities. The securities are complex, and some owners may not have fully understood their risk.

In response to market uncertainty, the Federal Reserve announced on Aug. 10 its intention to provide extra liquidity through open market operations. Similar operations were also carried out by most other major central banks around the world. Then, on Aug. 17, the Federal Reserve temporarily reduced the primary credit rate at the Fed's discount window to 50 basis points above the target federal funds rate and made available extended-term financing.

The challenges in the financial markets created uncertainty for the economic outlook. In response, the Federal Open Market Committee also reduced the target for the federal funds rate on Aug. 17 by 50 basis points to "help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

The financial markets have since stabilized somewhat. Nonetheless, many challenges remain. The origination of sub-prime mortgages has come to a standstill. At the same time, we are seeing a clear uptick in mortgage delinquencies-even before the sub-prime market hits the peak of mortgage rate resets! Moreover, housing inventories in many parts of the country are significant-including here in the Eighth District-and a number of communities are facing real housing price declines.

What does this mean for community banks? First, community banks are scouring their securities portfolio to understand what investment, if any, they have in non-GSE mortgage-backed securities. If so, they are attempting to define any impairment in value. Second, community banks are paying special attention to the risk management of their construction and land development portfolios. When the housing market faces pressure, so will developers and builders.

The next year or two will present challenges not faced by the industry in quite some time. To quote the Missouri Bank Commissioner, it will be "important to get the fundamentals right!"